The Problem of Cheap Oil

Only yesterday, it seems, we were bemoaning the high price of oil.
Under the headline "Oil's Rapid Rise Stirs Talk of $200 a Barrel This
Year," the July 7 issue of the Wall Street Journal warned that prices that high would put "extreme strains on large sectors of the U.S. economy." Today, oil, at over $40 a barrel, costs less than one-third what it did in July, and some economists have predicted that it could fall as low as $25 a barrel in 2009.

Prices that low -- and their equivalents at the gas pump -- will no
doubt be viewed as a godsend by many hard-hit American consumers, even
if they ensure severe economic hardship in oil-producing countries like
Nigeria, Russia, Iran, Kuwait, and Venezuela that depend on energy
exports for a large share of their national income. Here, however, is a
simple but crucial reality to keep in mind: No matter how much it
costs, whether it's rising or falling, oil has a profound impact on the
world we inhabit -- and this will be no less true in 2009 than in 2008.

The main reason? In good times and bad, oil will continue to supply
the largest share of the world's energy supply. For all the talk of
alternatives, petroleum will remain the number one source of energy for
at least the next several decades. According to December 2008 projections
from the U.S. Department of Energy (DoE), petroleum products will still
make up 38% of America's total energy supply in 2015; natural gas and
coal only 23% each. Oil's overall share is expected to decline slightly
as biofuels (and other alternatives) take on a larger percentage of the
total, but even in 2030 -- the furthest the DoE is currently willing to
project -- it will still remain the dominant fuel.

A similar pattern holds for the planet as a whole: Although biofuels
and other renewable sources of energy are expected to play a growing
role in the global energy equation, don't expect oil to be anything but
the world's leading source of fuel for decades to come.

Keep your eye on the politics of oil and you'll always know a lot
about what's actually happening on this planet. Low prices, as at
present, are bad for producers, and so will hurt a number of countries
that the U.S. government considers hostile, including Venezuela, Iran,
and even that natural-gas-and-oil giant Russia. All of them have, in
recent years, used their soaring oil income to finance political
endeavors considered inimical to U.S. interests. However, dwindling
prices could also shake the very foundations of oil allies like Mexico,
Nigeria, and Saudi Arabia, which could experience internal unrest as
oil revenues, and so state expenditures, decline.

No less important, diminished oil prices discourage investment in
complex oil ventures like deep-offshore drilling, as well as investment
in the development of alternatives to oil like advanced (non-food)
biofuels. Perhaps most disastrously, in a cheap oil moment, investment
in non-polluting, non-climate-altering alternatives like solar, wind,
and tidal energy is also likely to dwindle. In the longer term, what
this means is that, once a global economic recovery begins, we can
expect a fresh oil price shock as future energy options prove painfully
limited.

Clearly, there is no escaping oil's influence. Yet it's hard to know
just what forms this influence will take in the year. Nevertheless,
here are three provisional observations on oil's fate -- and so ours --
in the year ahead.

1. The Price of Oil Will Remain Low Until It Begins to Rise Again:
I know, I know: this sounds totally inane. It's just that there's no
other way to put it. The price of oil has essentially dropped through
the floor because, in the past four months, demand collapsed due to the
onset of a staggering global recession. It is not likely to approach
the record levels of spring and summer 2008 again until demand picks up
and/or the global oil supply is curbed dramatically. At this point,
unfortunately, no crystal ball can predict just when either of those
events will occur.

The contraction in international demand has indeed been stunning. After
rising for much of last summer, demand plunged in the early fall by
several hundred thousand barrels per day, producing a net decline for
2008 of 50,000 barrels per day. This year, the Department of Energy projects
global demand to fall by a far more impressive 450,000 barrels per day
-- "the first time in three decades that world consumption would
decline in two consecutive years."

Needless
to say, these declines were unexpected. Believing that international
demand would continue to grow -- as had been the case in almost every
year since the last big recession of 1980 -- the global oil industry
steadily added to production capacity and was gearing up for more of
the same in 2009 and beyond. Indeed, under intense pressure from the
Bush administration, the Saudis had indicated last June that they would gradually add to their capacity until they reached an extra 2.5 million barrels per day.

Today, the industry is burdened with excess output and insufficient
demand -- a surefire recipe for plunging oil prices. Even the December
17 decision by members of the Organization of the Petroleum Exporting Countries (OPEC)
to reduce their collective output by 2.2 million barrels per day has
failed to lead to a significant increase in prices. (Saudi Arabia's
King Abdullah said recently that he considers $75 a barrel a "fair
price" for oil.)

How long will the imbalance between demand and supply last? Until the
middle of 2009, if not the end of the year, most analysts believe.
Others suspect that a true global recovery will not even get under way
until 2010, or later. It all depends on how deep and prolonged you
expect the recession - or any coming depression -- to be.

A critical factor will be China's ability to absorb oil. After all,
between 2002 and 2007, that country accounted for 35% of the total
increase in world oil consumption -- and, according to the DoE, it is expected to claim
at least another 24% of any global increase in the coming decade. The
upsurge in Chinese consumption, combined with unremitting demand from
older industrialized nations and significant price speculation on oil
futures, largely explained the astronomical way prices were driven up
until last summer. But with the Chinese economy visibly faltering, such
projections no longer seem valid. Many analysts now predict that a
sharp drop-off in Chinese demand will only accelerate the downward
journey of global energy prices. Under these conditions, an early price
turnaround appears increasingly unlikely.

2. When Prices Do Rise Again, They Will Rise Sharply: At
present, the world enjoys the (relatively) unfamiliar prospect of a
global oil-production surplus, but there's a problematic aspect to
this. As long as prices remain low, oil companies have no incentive to
invest in costly new production ventures, which means no new capacity
is being added to global inventories, while available capacity
continues to be drained. Simply put, what this means is that, when
demand begins to surge again, global output is likely to prove
inadequate. As Ed Crooks of the Financial Times
has suggested, "The plunging oil price is like a dangerously addictive
painkiller: short-term relief is being provided at a cost of serious
long-term harm."

Signs of a slowdown in oil-output investment are already multiplying fast. Saudi Arabia, for example, has announced delays
in four major energy projects in what appears to be a broad retreat
from its promise to increase future output. Among the projects being
delayed are a $1.2 billion venture to restart the historic Damman oil
field, development of the 900,000 barrel per day Manifa oil field, and
construction of new refineries at Yanbu and Jubail. In each case, the
delays are being attributed to reduced international demand. "We are
going back to our partners and discussing with them the new economic
circumstances," explained Kaled al-Buraik, an official of Saudi Aramco.

In addition, most "easy oil" reservoirs have now been exhausted,
which means that virtually all remaining global reserves are going to
be of the "tough oil" variety. These require extraction technology far
too costly to be profitable at a moment when the per barrel price
remains under $50. Principal among these are exploitation of the tar
sands of Canada and of deep offshore fields in the Gulf of Mexico, the
Gulf of Guinea, and waters off Brazil. While such potential reserves
undoubtedly harbor significant supplies of petroleum, they won't return
a profit until the price of oil reaches $80 or more per barrel --
nearly twice what it is fetching today. Under these circumstances, it
is hardly surprising that the oil majors are canceling or postponing plans for new projects in Canada and these offshore locations.

"Low oil prices are very dangerous for the world economy," commented
Mohamed Bin Dhaen Al Hamli, the United Arab Emirates' energy minister,
at a London oil-industry conference in October. With prices dropping,
he noted, "a lot of projects that are in the pipeline are going to be
reassessed."

With industry cutting back on investment, there will be less
capacity to meet rising demand when the world economy does rebound. At
that time, expect the present situation to change with predictably
startling rapidity, as rising demand suddenly finds itself chasing
inadequate supply in an energy-deficit world.

When this will occur and how high oil prices will then climb cannot, of
course, be known, but expect gas-pump shock. It's possible that the
energy shock to come will be no less fierce than the present global
recession and energy price collapse. The Department of Energy, in its
most recent projections,
predicts that oil will reach an average of $78 per barrel in 2010, $110
in 2015, and $116 in 2020. Other analysts suggest that prices could go
much higher much faster, especially if demand picks up quickly and the
oil companies are slow to restart projects now being put on hold.

3. Low Oil Prices Like High Ones Will Have Significant Worldwide Political Implications:
The steady run up in oil prices between 2003 and 2008 was the result of
a sharp increase in global demand as well as a perception that the
international energy industry was having difficulty bringing sufficient
new sources of supply on line. Many analysts spoke of the imminent
arrival of "peak oil," the moment at which global output would commence
an irreversible decline. All this fueled fierce efforts by major
consuming nations to secure control over as many foreign sources of
petroleum as they could, including frenzied attempts by U.S., European,
and Chinese firms to gobble up oil concessions in Africa and the
Caspian Sea basin -- the theme of my latest book, Rising Powers, Shrinking Planet.

With the plunge in oil prices and a growing sense (however temporary)
of oil plenty, this dog-eat-dog competition is likely to abate. The
current absence of intense competition does not, however, mean that oil
prices will cease to have an impact on global politics. Far from it. In
fact, low
prices are just as likely to roil the international landscape, only in
new ways. While competition among consuming states may lessen, negative
political conditions within producing nations are sure to be magnified.

Many of these nations, including Angola, Iran, Iraq, Mexico,
Nigeria, Russia, Saudi Arabia, and Venezuela, among others, rely on
income from oil exports for a large part of their government
expenditures, using this money to finance health and education,
infrastructure improvements, food and energy subsidies, and social
welfare programs. Soaring energy prices, for instance, allowed many
producer countries to reduce high youth unemployment -- and so
potential unrest. As prices come crashing down, governments are already
being forced to cut back on programs that aid the poor, the middle
class, and the unemployed, which is already producing waves of
instability in many parts of the world.

Russia's state budget, for example, remains balanced only when oil
prices stay at or above $70 per barrel. With government income
dwindling, the Kremlin has been forced to dig into accumulated reserves
in order to meet its obligations and prop up sinking companies as well
as the sinking ruble. The nation hailed as an energy giant is running
out of money quickly. Unemployment is on the rise, and many firms are
reducing work hours to save cash. Although Prime Minister Vladimir
Putin remains popular, the first signs
of public discontent have begun to appear, including scattered protests
against increased tariffs on imported goods, rising public transit
fees, and other such measures.

The decline in oil prices has been particularly damaging to natural gas behemoth Gazprom,
Russia's biggest company and the source (in good times) of
approximately one quarter of government tax income. Because the price
of natural gas is usually pegged to that of oil, declining oil prices
have hit the company hard: last summer, CEO Alexei Miller estimated its market value at $360 billion; today, it's $85 billion.

In the past, the Russians have used gas shut-offs to neighboring states
to extend their political clout. Given the steep drop in gas prices,
however, Gazprom's January 1st decision to sever gas supplies to
Ukraine (for failure to pay for $1.5 billion in past deliveries) is, at
least in part, finance-based. Though the decision has triggered energy
shortages in Europe -- 25% of its natural gas arrives via
Gazprom-fueled pipelines that traverse Ukraine -- Moscow shows no sign
of backing down in the price dispute. "They do need the money," observed Chris Weafer of UralSib Bank in Moscow. "That is the bottom line."

Plunging oil prices are also expected to place severe strains on the
governments of Iran, Saudi Arabia, and Venezuela, all of which
benefited from the record prices of the past few years to finance
public works, subsidize basic necessities, and generate employment.
Like Russia, these countries adopted expansive budgets on the
assumption that a world of $70 or more per barrel gas prices would
continue indefinitely. Now, like other affected producers, they must
dip into accumulated reserves, borrow at a premium, and cut back on
social spending -- all of which risk a rise in political opposition and
unrest at home.

The government of Iran,
for example, has announced plans to eliminate subsidies on energy
(gasoline now costs 36 cents per gallon) -- a move expected to spark
widespread protests in a country where unemployment rates and living
costs are rising precipitously. The Saudi government
has promised to avoid budget cuts for the time being by drawing on
accumulated reserves, but unemployment is growing there as well.

Diminished spending in oil-producing states like Kuwait, Saudi
Arabia, and the United Arab Emirates will also affect non-producing
countries like Egypt, Jordan, and Yemen because young men from these
countries migrate to the oil kingdoms when times are flush in search of
higher-paying jobs. When times are rough, however, they are the first
to be laid off and are often sent back to their homelands where few
jobs await them.

All this is occurring against the backdrop of an upsurge in the
popularity of Islam, including its more militant forms that reject the
"collaborationist" politics of pro-U.S. regimes like those of Hosni
Mubarak of Egypt and King Abdullah II of Jordan. Combine this with the
recent devastating Israeli air attacks on, and ground invasion of, Gaza
as well as the seemingly lukewarm response of moderate Arab regimes to
the plight of the 1.5 million Palestinians trapped in that tiny strip
of land, and the stage may be set for a major upsurge in
anti-government unrest and violence. If so, no one will see this as
oil-related, and yet that, in part, is what it will be.

In the context of a planet caught in the grip of a fierce economic
downturn, other stormy energy scenarios involving key oil-producing
countries are easy enough to imagine. When and where they will arise
cannot be foreseen, but such eruptions are only likely to make any
future era of rising energy prices all that much more difficult. And,
indeed, prices will eventually rise again, perhaps some year soon,
swiftly and to new record heights. At that point, we will be confronted
with the sort of problems we faced in the spring and summer of 2008,
when raging demand and inadequate supply drove petroleum costs ever
skyward. In the meantime, it's important to remember that, even with
prices as low as they are, we cannot escape the consequences of our
addiction to oil.